July-August 2014

In December 2012 the UK’s financial services watchdog highlighted the need for asset managers to have contingency plans if they use the services of an operational outsourcing provider. Of particular concern to the Financial Services Authority, since reformed as the Financial Conduct Authority (FCA), was the fact that so much of the outsourcing market was entrusted to a small group of mostly bank-based global custodians and, should one of these run into financial difficulties, managers could face an operational disaster.

The industry’s response to the regulator’s investigation of outsourcing contingency planning was to form the Outsourcing Working Group (OWG) that pulled together all the global custodians, 15 of the largest asset managers, the Investment Management Association to represent other asset managers, and the Big Four audit firms.

Mark Westwell, a regional client management executive for State Street Global Services, was the chairman of the OWG. The brief given by the regulator, says Westwell, was to produce something that was viable, robust and realistic. “We avoided words like check-list and guidelines and instead used considerations and principles,” he says.

EXIT PLANNING“All asset managers have their own unique business models and rather than try to work with something prescriptive, they prefer to adopt principles that best fit their model so that they are able to justify to the regulator what parts they did not specifically adopt.” In December 2013, seven months after its first meeting, the OWG published its guiding principles document. It focused on the three key areas agreed with the FCA – namely oversight, exit planning and standardisation – and recorded a number of principles for each.

For example, four principles were noted for the oversight function: know your outsourcer; hold a risk-based assessment; ownership; and governance framework. Seven principles were noted for exit planning, including creating a comprehensive exit plan, reviews, key documents and transition governance.

The last area – standardisation – was the most challenging given the breadth of different operating models used by asset managers but the OWG suggested that some standards could be agreed for documenting their operating models, thereby making it easier to establish new relationships with providers and coordinate technology should a contingency plan be invoked.

Westwell says the OWG’s work has been well received by the FCA to the point where, when the regulator visits an asset manager, it should be able to audit their contingency arrangements against the guiding principles. However, the FCA has not yet revisited any asset managers nor made any comment on the subject since December 2013.

Meanwhile the OWG has disbanded. “We came together for a particular mission,” says Westwell. “We wanted it to be meaningful and close-ended.

ONE-OFF PROCESSA consequence of six months of inactivity on the subject is that some asset managers have seen it as a one-off process rather than a constant practice that reflects any changes in the market or the manager’s business model, says Steve Young, chief executive at consultant Citisoft.

“The FCA needs to make a statement to keep the industry interested. The issue has gone to business-as-usual status.

“The attention has dropped right off and that has led to an element of complacency.

“There is no obvious deadline so no one feels like this is a burning issue, particularly the small and medium managers.”

Another criticism is that a lot of firms have taken their guidelines from providers themselves, says Young. “The outsourcers have been very proactive but there should be more independent work done by the asset managers. The FCA is not looking for a cosy relationship between asset managers and their providers.”

However, Westwell says it was important for service providers to produce a range of standard material to replace what was already an ad-hoc and heavily bespoke range, and he says that this means asset managers are doing their own due diligence on services providers but in a more standardised framework.

If is not the intention that asset managers simply apply the standard template. “As global custodians, our lives would be much easier if that was the case but the asset managers all need to understandably differentiate themselves. They will take that material and tweak it with their provider to a manner that suits their business model.”

So far the focus on providers is limited to global custodians, which may be short-sighted, suggests Young. “The industry has prioritised outsourcing by size and scale of operation. They should be doing so by risk, which is not necessarily commensurate with size. For example, derivatives outsourcing holds a big risk but the scale may be small.”

One of the issues in exit planning is the consolidation among global custodians. There are few options for asset managers so it is as much about capacity as capability, says Young. “It would be good to have a more competitive market for outsourcing. There are shadow arrangements but if one global custodian went out of business, it would create huge capacity issues.” An asset manager should be able to move at a time of their choosing but this needs strong oversight, says Young. “Managers also need to look at their own internal controls – strategy, asset class structures, expansion plans – and how they influence the outsourcing relationship. It is not always an external issue.

“For example, how much does manual processing need to be supported, especially in something like derivatives? Is it possible to bring that capability in-house? This is something the industry has not really addressed, which is down to cost, but as the industry recovers, hopefully it is something they can look at.”

BAULKING AT THE COSTSThe cost debate is a common one in any discussion about business continuity planning (BCP), says Paul Wiltshire, managing director of UK-based consultant CityIQ and someone who has a background in BCP. “Businesses used to baulk at the cost of doing BCP properly and there are the same issues with this.”

There are three other ways to mitigate the risk of being unable to operate should a major outsourcing provider go down: employ a permanent shadow service, as was the case with Bridgewater in the US; split outsourcing between multiple providers so as to lessen exposure to one provider; or come to a stand-by arrangement with another provider to ensure that you are top of the list if your current provider goes down.

All of these strategies will be costly though, which has opened the door to a number of technology and data vendors to step into the breach and offer a variety of services designed to act as cost-effective alternatives to shadow services.

Data management vendor Markit is selling an insulation layer to both custodians and asset managers where the data the manager is receiving from the outsourced provider and its own internal system resides with Markit, facilitating the collation and transfer of data, says Paul McPhater, chief operations officer for Enterprise Software at Markit. It allows managers to shift outsourcing provider. It is also a cost-effective option and a full-blown shadow service, he says.

And in December 2013 SimCorp, an investment management software vendor, released a shadowing service designed to act as a low-cost utility for asset managers as they change providers. Rather than employing a full-time shadow service from another global custodian, the clients can use the SimCorp service to replicate everything needed to run the portfolios and provide investors with redemptions.

“The service started by supplying net asset values and then an investment book of record for any trading activity. But we soon realised that different managers have different needs,” says Cath Rawcliffe, sales and marketing director at SimCorp. “Some managers wanted to include pre-trade compliance checks, others wanted an execution capability.”

Rawcliffe says there are managers at the proof-of-concept stage; but most firms are waiting to see what the FCA decides before committing. “These things often take time and the industry has been very mature in taking the FCA’s proposals on board.”

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